Category: Litigation

Thinking of conditioning the settlement of a customer arbitration claim on the customer agreeing to expunge her complaint against you? Think again. The FINRA is now awaiting the SEC’s approval of a FINRA rule proposal that would prohibit associated persons from conditioning settlements of customer disputes on, or otherwise compensating customers for, an agreement not to oppose a request to expunge information from an associated person’s Central Registration Depository (CRD) record. Continue reading “The End of Not Opposing Expungements in Return For Settlement?”

FINRA’s action against J.P. Turner is another reminder of the need for broker-dealers to carefully scrutinize the suitability of such non-conventional investments products like inverse exchange-traded funds.

Two SEC enforcement cases last week demonstrate (i) how using affiliated brokerage on an agency or principal basis raises potential conflicts of interest when dealing with ” best execution” concerns , and (ii) the importance of having robust best execution policies and procedures and then following them. In both cases, the SEC sanctioned investment advisers for not heeding these concerns in failing to seek best execution on client trades placed through in-house brokerage divisions.

While the duty of an adviser or fund to seek best execution may not expressly be stated in the federal securities laws, to the extent they are typical, these cases tend to follow a pattern: An SEC best execution enforcement action might involve the SEC’s examination staff first finding that a firm failed to disclose compensation on client brokerage, failed to adequately its brokerage practices or failed to properly disclose to clients the adviser’s best execution policies and procedures. The two recent cases are no exception.

In the first case against A.R. Schmeidler & Co. (ARS), a dually registered investment adviser and a broker-dealer, the SEC found that ARS failed to reevaluate whether it was providing best execution for its advisory clients when it negotiated more favorable terms with its clearing firm. This resulted in ARS retaining a greater share of the commissions it received from clients, a best execution violation. The SEC found that the firm also failed to implement policies and procedures reasonably designed to prevent the best execution violations. To settle the SEC charges, ARS agreed to pay disgorgement of $757,876.88, prejudgment interest of $78,688.57, and a penalty of $175,000. The firm also must engage an independent compliance consultant, and had to consent to a censure and cease-and-desist order.

The second case involved a CEO who also served as Chief Compliance Officer officer, Goelzer, and his Indianapolis-based dually registered firm Goelzer Investment Management (GIM). The SEC found that GIM made misrepresentations in its Form ADV about the process of selecting itself as broker for advisory clients. The SEC found that GIM failed to seek best execution for its clients by neglecting to conduct the comparative analysis of brokerage options described in its Form ADV, and recommended itself as broker for its advisory clients without evaluating other introducing-broker options as the firm represented it would. Goelzer and GIM agreed to pay nearly $500,000 to settle the charges that included GIM paying disgorgement of $309,994, prejudgment interest of $53,799, and a penalty of $100,000. The firm was also required to comply with certain undertakings, including the continued use of a compliance consultant and the separation of its chief compliance officer position from the firm’s business function. Goelzer agreed to pay a $35,000 penalty, and Goelzer and GIM consented to censures and cease-and-desist orders.

What are some of the lessons for advisers and funds engaged in managing potential conflicts related to best execution?

While the SEC provides no specific definition of “best execution,” it has said that managers should seek to execute securities transactions for clients in such a manner that the client’s total cost or net proceeds in each transaction is most favorable under the circumstances. The determinative factor is not necessarily the lowest commission cost, but whether the transaction represents the best qualitative execution for the managed account. So what should advisers learn from these cases?

Recognize the importance of having strong written policies and procedures that provide guidance concerning the quality of trade execution while, at the same time, attending client investment objectives and constraints.

Make sure that disclosures in Form ADV and elsewhere include information about trading and actual and potential trading conflicts of interest.

Document compliance with best execution policies and procedures and disclosures to clients.

Consider setting up a brokerage or trade management committee to review trade placement and best execution. The committee should address such topics as broker trading cost and execution, brokerage expertise and infrastructure and the broker’s willingness to explore alternative trading options.

Test for best execution, including possibly hiring a third party service provider to periodically assess the broker’s capacity to evaluate which competing markets, market makers, or electronic communication networks (ECNs) offer the most favorable terms of execution, the speed of execution, and the likelihood that the trade will be executed.

There are numerous sources to consult when thinking about and developing best execution policies. A few advisers might want to consider include: Trade Management Guidelines (Nov. 2002), available at www.dfainstitute.org/standards/ethics/tmg; See Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matters, Exchange Act Release No. 23170 (Apr. 23, 1986) (“1986 Soft Dollar Release”); Lori Richards, Valuation, Trading, and Disclosure: The Compliance Imperative, Remarks at the 2001 Mutual Fund Compliance Conference of the Investment Company Institute (June 14, 2001), available at www.sec.gov/news/speech/spch499.htm.

In statements following these cases, the SEC warned all investment advisers with affiliated broker-dealers that it would hold them accountable to ensure clients are obtaining the most beneficial terms reasonably available for their orders.

The past two weeks has seen the SEC’s continued ratchet upward the number of enforcement actions against municipal securities participants for disclosure violations.

These enforcement actions also continue to ensnare an array of players in municipal securities transactions, that include underlying obligors, their chief executive officers, national and regional investment banks, the heads of public finance departments at several investment banks, as well as individual investment bankers at various levels of seniority, issuers, issuer officials, financial advisers, attorneys and accountants.

The cases have involved everything from tax or arbitration-driven fraud, pay-to-play and public corruption violations, public pension accounting and disclosure fraud, valuation/pricing issues, and most recently, more offering offering and disclosure fraud, involving misleading statements or omissions in offerings.

Two recent enforcement actions illustrate this trend. The first, SEC v. City of Miami, Florida and Michael Boudreaux, an SEC complaint filed in federal court in Miami alleged that the City of Miami, through its then Budget Director, charged that beginning in 2008, the City and the budget director made materially false and misleading statements and omissions concerning certain interfund transfers in three 2009 bond offerings totaling $153.5 million, as well as in the City’s fiscal year 2007 and 2008 Comprehensive Annual Financial Reports. The City puportedly transferred a total of approximately $37.5 million from its Capital Improvement Fund and a Special Revenue Fund to the General Fund in 2007 and 2008 in order to mask increasing deficits in the General Fund.

The complaint alleged that the City and the budget director failed to disclose to bondholders that the transferred funds included legally restricted dollars which, under Miami’s city code, was not permitted to be commingled with any other funds or revenues of the City. The defendants also failed to disclose that the funds transferred were allocated to specific capital projects which still needed those funds as of the fiscal year end or, in some instances, already spent that money. The transfers enabled the City of Miami to meet or come close to meeting its own requirements relating to General Fund reserve levels. According to the SEC, the results of the transfers, meant that the City’s bond offerings were all rated favorably by credit rating agencies.

The second and most recent case, In The Matter of West Clark Community Schools, a settled administrative cease-and desist proceeding, involved the West Clark Community Schools, an Indiana school district. In 2005, theWest Clark Community Schools contractually, in accordance with SEC rules, undertook to annually disclose certain financial information, operating data and event notices in connection with a $52 million municipal bond offering. In 2007, the school district, in connection with a $31 million municipal bond offering, stated in public bond offering documents that it had not failed, in the previous five years, to comply in all material respects with any prior disclosure undertakings. That statement, the SEC alleged, as well as a Certificate and Affidavit signed by the School District attesting that the offering documents did not contain any untrue statement of material fact, was materially false. To the contrary, the SEC found that between at least 2005 and 2010 the School District never submitted any of its contractually required disclosures.

As a result, the SEC claimed that the school district violated Section 17(a)(2) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5(b) thereunder. In a separate, but related, settled cease-and-desist proceeding, In the Matter of City Securities Corporation and Randy G. Ruhl, the SEC found that City Securities, the underwiter, and an vice president of City Securities’ municipal bond department conducted inadequate due diligence and, as a result, failed to form a reasonable basis for believing the truthfulness of material statements in an the school district’s official statement, resulting in City Securities offering and selling municipal securities on the basis of a materially misleading disclosure document.

In addition to being censured, City Securities was ordered to pay disgorgement and civil penalties. The vice president was barred from the securities industry with a right to reapply after one year and ordered to pay disgorgement and civil penalties.

In July 2012, the SEC issued a comprehensive report with recommendations aimed at helping improve the structure and enhance disclosure provided to investors for a municipal securities market that has grown to $3.7 trillion in municipal debt outstanding from a level of $361 Billion in 1981. To that, add potential enforcement actions from the MSRB, states, and other SROs, and there’s little doubt that the enforcement action trend will escalate.

Reporting on Mary Jo White’s speech at a Wall Street CFO Network function, the Washington Post notes her comments about the long-simmering topic of failure of securities law violators to admit guilt when they settle with the SEC. As a matter of practice, the SEC has routinely allowed defendants to settle cases “without admitting or denying wrongdoing.” In light of public criticism and some pointed criticisms by judges handling these type settlements(See my December 15, 2011 blog post ), White wants to draw a sharper distinction between those cases where clear-cut misconduct is shown and those cases where wrongdoing or guilt is less clear.

The Washington Post article notes that “[i] an e-mail sent to the SEC staff earlier this week, the co-directors of the enforcement division said that cases in which the defendant engaged in “egregious intentional misconduct” may justify requiring an admission, as would the obstruction of an SEC investigation or “misconduct that harmed large numbers of investors.”

Despite public protestations, and some courts’ misgivings about allowing defendants to pay large fines to settle cases without admitting wrongdoing, wholesale changes in the settlement policy are unlikely. Further, district courts have limited authority to change an executive branch agency’s decision to settle a claim, including the SEC’s “neither admit nor deny” policy.

Whether a sharper line is drawn or not, such settlements still serve an important public policy. Similar to the rationale for plea bargaining in criminal cases, without being able to settle without admitting guilt, many defendants would not settle. Some defendants would rather risk going to trial than admit guilt that might leave them open to other lawsuits, denial of insurance coverage, or higher insurance premiums. Still other defendants, lacking resources, might simply consider walking away from these cases. The result — long investigations and trials with even harsher fines and sanctions that may go uncollected and waste limited resources.

Effective July 1, 2013, add to the types of individuals who are no longer eligible to serve as public arbitrators in FINRA arbitrations persons associated with, or registered through, a mutual fund or hedge fund.

The list has been growing and already includes (i) attorneys and accountants who derive a certain percentage or a certain amount of their income from the securities industry, (ii) investment advisers, (iii) persons or spouses employed by entities involved in the securities industry, and (iii) directors or officers or spouses or an immediate family member of a person who is a director or officer of, an entity that directly or indirectly controls, is controlled by, or is under common control with, any partnership, corporation or other organization that is engaged in the securities business.

Despite complaints from some in the securities industry that the change means more arbitrators with less experience and education about how the securitie industry works, the rationale approved by the SEC and adopted under Codes of Arbitration Rules (Customer and Industry Codes) 12100(u)(3) and 13100(u)(3) for including these categories is just the opposite. The change arises from complaints that certain arbitrators on FINRA’s public arbitrator roster are not perceived as public and may be biased because of their industry background and experience. The exclusion is not permanent. If the individual ends the affiliation that was the basis for the exclusion, they are eligible to serve as a public arbitrator two calendar years after ending the affiliation.

In a press releaseyesterday, the Securities and Exchange Commission announced enforcement results for its fiscal year ending September 30, 2012.

The results include the SEC having filed 734 enforcement actions, just one case shy of last year’s record of 735. According to the Division of Enforcement, the cases, involved everything from highly complex products, transactions, and practices, including those related to the financial crisis, trading platforms and market structure, to insider trading by market professionals. In addition, orders were entered in some of these cases requiring the payment of more than $3 billion in penalties and disgorgement for the benefit of investors who were harmed.

Investment Advisers

As for investment advisers, the SEC filed 147 enforcement actions in 2012 against investment advisers and investment companies. Several cases resulted from the Division of Investment Management’s investment adviser compliance initiative involving advisers who failed to maintain effective compliance programs designed to prevent securities laws violations.

bringing an action against OppenheimerFunds for misleading investors in two funds suffering significant losses during the financial crisis.

Broker-Dealers

The Commission filed 134 enforcement actions related to broker-dealers — a 19 percent increase over 2011. Enforcement actions included an action against a Latvian trader and electronic trading firm for their involvement in an online account intrusion scheme that manipulated the prices of more than 100 NYSE and Nasdaq securities; and an action against New York-based brokerage firm Hold Brothers On-Line Investment Services and three of its executives for allowing overseas traders to access the markets and conduct manipulative trading through accounts the firm controlled.

Municipal Securities

The number of enforcement actions related to municipal securities more than doubled since 2011. The SEC filed 17 actions related to municipal securities, including charging Detroit’s former mayor and treasurer in a pay-to-play scheme involving Detroit’s pension funds. In another action, the SEC charged Goldman Sachs for violating municipal securities rules resulting from undisclosed “in-kind” non-cash contributions that one of its investment bankers made to a Massachusetts gubernatorial candidate.

Back on July 25, 2011, we blogged about the importance attached to chief compliance officers’ understanding the regulatory framework and guiding principles for what it is they do. As we said then,

“Rule Number One

: Your Job is to “Administer” the Compliance Program: The CCO’s job function as mandated by Rule 206(4)-7 (the “rule”) is limited to “administering” the investment adviser’s compliance policies and procedures. While the rule contains no explicit definition for what the term administering means, the rule makes one thing clear, it is the adviser who is legally required to “adopt and implement written policies and procedures reasonably designed to prevent violation” of the Investment Advisers Act of 1940. What this means is that you are not the guarantor that your adviser will not experience a compliance failure. Nor is it necessarily true, from a supervisory perspective, that you are responsible for the compliance failures of others in the firm. To the contrary, the failure of a compliance program to find and remedy compliance problems can just as easily be viewed as evidence that the adviser’s compliance program, including its policies and procedures, are not effective.

This doesn’t mean that compliance personnel of an adviser can’t be sanctioned for not properly supervising employees. Of course, they can be and are sanctioned. However, the fact that you are a CCO does

not, in and of itself, give you supervisory responsibility over your adviser’s personnel. In short, if you’re not supervising other advisory personnel, and you limit supervisory responsibility to persons who are part of the compliance staff, the Adopting Release to the rule makes clear that you aren’t necessarily liable for the supervisory lapses of your adviser. ……..”

The signficance of this rule is born out in an article appearing in AdviserOne entitled “” makes reference to a report prepared by the law firm of Sutherland Asbill tracking recent regulatory actions involving CCOs and in-house attorneys facing disciplinary actions covering everything from lapses involving inadequate supervisory systems, anti-money-laundering (AML) compliance program, inadequate due diligence in private offerings, books and records violations to lying to regulators.

Understanding and remembering first what your role is as CCO or in-house counsel may prove to be the only thing separating you and a regulatory sanction.

Add a few recent SEC actions against hedge funds that include a hedge fund manager running a $37 million Ponzi scheme; a former director in a compensation scheme that netted hundreds of thousands of dollars in undisclosed income; co-founders of a Chicago-area investment firm misleading investors and supervisory failures resulting in penalties of more than $1 million; a private fund manager and his investment advisory firm taking more than $17 million in losses in a Ponzi-like scheme.

And now add to that two even more recent cases: a hedge fund manager over the course of several years invest the majority of a fund’s assets in a private business owned by the manager’s affiliated company; and a manager who used his hedge fund as a ruse to misappropriate over $550,000 from a retired schoolteacher, and you get the math of why SEC hedge fund oversight will continue to intensify. Given many of the enforcement actions in the past two years are the result of fairly egregous conduct, the SEC Office of Investor Education and Advocacy’s most recent Investor Bulletin is still instructive, not simply for investors, but also, for the hedge funds who serve them.

The bulletin warns investors about continued hedge fund-related misconduct in the markets while mentioning these cases as examples of why investors need to take precaution before making hedge fund investments. While there’s nothing surprising about precautions and recommendations that include

a need for investors to understand a hedge fund’s investment strategy and its use of leverage and speculative techniques before making the investment;

a need for investors to evaluate a hedge fund manager’s potential conflicts of interest and take other steps to research those managing the fund;

the bulletin highlights the need for registered advisers to hedge funds to pay particular attention to conflicts of interest when making investment decisions, particularly when determining how investment opportunities are allocated. Advisers also have to be wary about engaging in principal transactions when managing hedge funds — for example, engaging in rebalancing or other types of cross trades. Among others, they should concern themselves with the valuations assigned to particular securities, and calculations of all fees and other income sources.

For hedge fund advisers, these bulletins, whose primary aim is educating the investing public, are another way to take a deeper look for potential conflicts that may lead to violations and to understand the emphasis SEC examiners and regulators will place on such conflicts.

Last week, in the ever-evolving “employee versus independent contractor” battle, Judge Anthony Battaglia of the U.S. District Court for the Southern California in a decision added additional fuel in a decision in the broker-dealer/registered representative arena. Battaglia upheld Waddell & Reed’s classification of its reps as independent contractors, ruling against two brokers who claimed that they should have been treated as employees. Earlier, in 2010, the court refused to dismiss a putative class action against Waddell & Reed that alleged that the financial services giant misclassified its financial advisors or registered representatives as independent contractors rather than employees. In the current decision, the court granted Waddell’s motion for two summary judgments, but allowed the two former rep/plaintiffs to add a third broker to their suit.

Clearly, the Taylor v. Waddell & Reed ruling is, by no means, the last word on the issue. And, don’t expect the SEC and FINRA to weigh in any time soon. Nor should broker-dealers expect that simply enhancing a boiler-plate employment contract provision will necessarily do the trick.

Further, the classification of workers as independent contractors will continue to draw scrutiny from the Department of Labor, the Internal Revenue Service, state agencies and legislatures, and the plaintiffs’ bar. For broker-dealers this may mean, at a minimum, three considerations. First, broker-dealers will need to review how they utilize their registered representatives’ services. Second, they’ll need to have a clear understanding of the laws they’re relying on for the independent rep classification. Finally, they’ll need to consider the legal exposure and what proactive steps may be necessary (i.e. potential liability) if they’ve been misclassifying a particular rep.

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This blog identifies and discusses new and developing regulatory issues that impact investment advisers, broker-dealers, corporations and individuals who either work in the securities industry or who are impacted by its regulations.